What are Bonds and Debentures?
Bonds and debentures are two of the most frequently used debt investment options for investors. While debentures are issued by companies in the form of convertible or non-convertible debt securities, bonds are issued by either government agencies or companies as certificates of debt to raise funds. In fact, in the US, a debenture is considered the type of bond with no collateral security, while in most countries, both terms are used interchangeably.
Whether a small enterprise, a large multinational company, or a government agency, every entity needs to raise funds to run its operational activities, and that is when some of these entities decide to borrow from the public. While there are many different ways of borrowing money, bonds and debentures are the most prominent ones among the available options.
Characteristics of Bonds and Debentures
The bonds exhibit the following characteristics:
- The bonds have a face value or par value that is paid to the bondholder at the time of maturity. It is usually $1,000 corporate bonds, but it can be greater for government bonds.
- In most bonds, the coupons are paid every 6 months, but they can also be monthly, quarterly or annually.
- The maturity period can be as pintsize as 1 day that can go up to 30 years. The thumb rule is that the coupon rate is directly proportional to the maturity period –the longer the maturity period higher is the coupon rate.
The debentures exhibit the following characteristics:
- Usually, the debentures are part of a series issued over a particular period of time.
- The holders of debentures are creditors for a company, and thus they don’t possess any voting rights.
- The interest rate paid on debentures is fixed in nature.
- The debentures are long-term funding sources, and the maturity period usually falls in the range of 10 to 20 years.
How to Invest in Bonds and Debentures?
To invest in bonds and debentures, one should have a trading and Demat account. The investors can either trade themselves or ask the brokers to trade on their behalf. However, the decision of investment should be made based on the period of repayment and the expected rate of return of the securities.
Types of Bonds and Debentures
The bonds can be broadly categorized into the following types:
- Actively managed bonds: The fund managers of these types of bonds actively trade the funds to achieve the investment goal of higher returns as compared to the market.
- Passively managed bonds: The fund managers of these types of bonds benchmark the fund allocation to a particular index such that the fund performance mimics that of the index, and thus these bonds are also known as index funds.
- Open-end bonds: In these types of bonds, the fund managers can make new offers in the market to either meet additional fund requirements or redeem the existing ones. The existing investors can re-invest in the new fund offerings after redeeming their investments.
- Closed-end bonds: In these types of bonds, the number of tradable shares is limited. These bonds can be either actively managed or index funds.
- Exchange-traded funds: These funds are bouquets of various bonds with an unlimited number of shares. These bonds are traded on the exchange through brokers and thus the name.
The debentures can be broadly categorized into the following types:
- Convertible debentures: These types of debentures come with the option of conversion into equity shares or securities. Some of the debentures are partly convertible, while some are fully convertible.
- Non-convertible debentures: These types of debentures can’t be converted into equity shares or securities. Typically, the non-convertible debentures offer a higher return as compared to the convertible debentures.
- Secured debentures: Collateral securities back these types of debentures in the form of the company’s assets.
- Unsecured debentures: Any kind of collateral securities does not back these types of debentures.
Difference Between Bonds and Debentures
Now, let us look at some of the major differences between bonds and debentures.
|They are usually secured by a claim against company assets.||Not all debentures are secured by collaterals.|
|They are issued by corporations, government agencies, or financial institutions.||They are mostly issued by private companies.|
|They are relatively less risky.||These are at relatively higher risk.|
|In the case of company liquidation, bonds are placed higher on the priority list.||In the case of company liquidation, debentures are placed below bonds and above equity & preference shares on the priority list.|
|They offer a relatively lower rate of interest.||They provide higher interest rates.|
Some of the major advantages of bonds and debentures are as follows:
- Both bonds and debentures are considered to be best suited for conservative investors.
- The prices of bonds and debentures are more stable as compared to equity shares.
- They are significantly cheaper sources of funding as compared to equity funding.
Some of the major disadvantages of bonds and debentures are as follows:
- The interest paid on bonds and debentures is cumulative in nature, which means that it had to be paid irrespective of whether the issuing entity earns a profit or incurs a loss. This can result in a significant financial burden for the companies during economic downturns.
- These investors neither have any representation in the company management nor do they have any voting rights. Thus, they have no control over company affairs.
So, it can be seen that various companies and government agencies raise funds by issuing bonds and debentures. Both of these are debt funds, and mostly the conservative investors participate. Additionally, some of the debentures come with the option of conversion to equity shares or some other forms of securities. As an investor, one needs to take into account the period of repayment and the expected rate of return before investing.
This is a guide to Bonds and Debentures. Here we also discuss the introduction and how to invest in bonds and debentures? along with advantages and disadvantages. you may also have a look at the following articles to learn more –